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Chapter 28.docx

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Marilyn Cottrell

Chapter 28: Money, Interest Rates, and Economic Activity Financial Assets: 1. Money- currency plus checkable deposits 2. Bonds- bought and sold in bond market Bond is a promise to make payments at dates in future. Present value is the current value of one or more payments or receipts made in the future- the (discounted) present value (PV) of the bond. The present value of any asset [e.g. bond] that yields a stream of payments over time is negatively related to the interest rate. Present Value and Market Price  PV of an asset is the highest price someone would pay to own the future stream of payments from the asset.  Any price lower than the present value creates excess demand for the asset- drives up the assets price.  The equilibrium market price of an asset is the PV of the income stream that the asset produces. The Interest Rate Market Price  Negative relationship between interest rates and asset prices 1. If interest rate falls Present value of an asset with a given income stream will rise 2. A rise in market price of an asset with a given income stream Is equivalent to a decrease in rate of return earned by the asset.  Downward sloping money demand curve  At any given time the money supply is constant  Equilibrium is at I* where MD=MS MS>MD: high rates of interest  Excess supply of money- buy bonds  Capital gain  drive down cash balances  i1 decrease -> i* Pb increase At a low rate of i  Expect i to rise  Excess demand for money  Sell bonds  Avoid capital loss  Drive up cash balances  I increase -> i* Pb decrease Stocks and Bonds Income-earning assets:  Bonds (debts) generate a stream of interest payments  Stocks (equity) generate a stream of dividend payments Demand for money:  Lump all income-earning assets as ‘bonds’ “Bonds”  Earn interest “Money”  Earns no interest The Demand for Money  Money balances you want to hold Opportunity cost of holding any money balance  Is interest earned if money used to purchase bond Three motives for holding money:  Transactions motive  Precautionary money  Speculative money The Transactions Motive Transactions balances  Money balances held to make payments If GDP is larger  More transactions  Economy holds larger transactions balances If interest rate is higher  Fewer transactions balances held  Interest rate is opportunity cost of holding money The Precautionary Motive Precautionary balances  Held to protect against uncertainty of the timing cash flows If interest rate is high  Fewer precautionary balances are held  Higher opportunity cost The Speculative Motive Speculative balances  Held because of uncertainty of prices of financial assets  Bonds If interest rates change  Bond prices change  Rate of return uncertain Hold money to diversify  Financial portfolio  Reduce risks At higher interest rates  Opportunity cost of holding money rises  Households (HH) and firms hold less money Real vs. Nominal Money Nominal money [M]  Actual amount of money  Currency plus bank deposits Real Money [M/P]  Nominal money divided by the price level  It is the purchasing power of the money If price level rises by 10%  Nominal money rises by 10%  Real money is constant Real and Nominal Money Balances Change in price level:  Does not change demand for real money balances  Does affect demand for nominal money balances Ceteris paibus, nominal demand for money balances varies in direct proportion to price level Monetary transmission mechanism:  Changes in supply and demand for money affect aggregate demand Three Stages: 1. Change in money demand or supply changes equilibrium interest rate 2. Change in interest
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